Consolidating Debts - What to Watch Out For

Many Australians now carry a heavy burden of debt. Debt has become very easy to get into, and you may find you'll be offered extra credit on your credit card or an extended home loan, sometimes even without asking.

As a result, it's also easier to over-extend yourself. On top of that, managing your payments for credit cards, store cards, personal loans and a home loan, all charging different interest rates, can become a complicated business.

If you have a problem managing your debts, rolling all your loans together into a single loan can sound very attractive. But is this loan consolidation, as it's often called, really that attractive?

Unless you use consolidation to break the cycle of spending more than you earn and getting debt in the first place, then consolidation will be a purely cosmetic, short-term operation, like using liposuction for obesity.

What to watch out for when consolidating debts

1. Interest rates, fees and costs
   The most important thing to get right when you borrow money is the interest rate. Make sure your new interest rate, including fees and costs, is significantly lower than what you're paying over all the debts you're consolidating. If you end up paying higher interest, you're losing money and making your problem worse.
   If you have a home loan, one do-it-yourself option, would be to re-draw against your home loan or seek an extension of your home loan to pay out all your higher-interest loans. Increase your home loan repayments by as much as you can afford to pay off the extra debt as soon as possible.
    
2. Hidden costs
   Existing loans may impose penalties or costs if you pay them off early. Your new consolidation loan may be secured against your home or other assets, which means you may have to pay for applying, legal work, valuation and stamp duty.
    
3. Making yourself and others more exposed
   If all of your unsecured debt is turned into a secured debt over the family home, then you've created some extra risk that your home could be on the line if things go wrong.
   If your home is owned with someone else, either as 'tenants in common' or 'joint tenants', they will also be liable for any new loan that's secured over the whole property. Similarly, if you have to ask someone to be a guarantor for your new loan, you will be exposing them to financial risk.
   This means your partner or family could end up shouldering responsibility for your debts. This could reduce their equity and make them vulnerable to the loss of the home, particularly if interest rates go up and/or property prices fall.
    
4. Getting in deeper
   Consolidation may allow you to borrow even more money. For example, if your existing credit card balances are transferred onto your home loan, as part of the debt consolidation, then you might be tempted to put new debt on to your credit cards. Or, if you get a line of credit, your borrowing limit may be greater more than your current debts. If you use the consolidation loan simply to increase your overall level of debt, you will probably make your financial problems even worse.
    
5. Churning
   Some mortgage brokers or lenders make a commission if they persuade you to switch loans. Sometimes they make misleading claims about how much you could save in order to sell you a new loan, especially lines of credit.
    
6. Outright exploitation
   At the extreme, some loan sharks exploit consumers in deep financial trouble by offering them a 'lifeline' of a debt consolidation loan secured over their house.
   Such loan sharks know full well that the borrower has no realistic hope of paying off the loan. The consolidation loan is usually at a higher interest rate, with significant extra fees and costs, for brokerage, application, legals, etc. Soon afterwards, the consumer defaults on the new loan and their home is sold up. The consolidation process has been deliberately used to strip someone of what they owned just for the benefit of the broker, lender and those associated with them.
   Check what a bank, credit union or building society can offer you. If they can't help, you may be better off forgetting the loan consolidation option. If you are having trouble paying your debts now, you stand little chance of paying back a loan with a sky-high interest rate.
    
7. Your repayment record
   Even if you consolidate your debts you will still need to set up a disciplined program to pay off your loan.

© Copyright ASIC, 10 November 2004. http://www.fido.asic.gov.au/fido/fido.nsf/byheadline/Consolidating+debts%3A+what+to+watch+out+for?openDocument